Tax Rates heavily influence investor behavior and therefore where the money flows and which asset types have better or worse relative performance.
We all know that taxes will be rising as a result of the almost unbelievable level of debt issued by the US, and the the enormous overhang of unfunded social program liabilities, which March Faber estimates in the aggregate to be 8 times GDP.
Nobody knows for sure how far taxes will rise or how they will be structured, but a look at the past may give some clues. Certainly, politicians will look at the past for ideas, so investors might benefit from a look at the past as well.
Big questions arise about the future appeal of equity income stocks versus low-dividend or no-dividend stocks, and stocks versus bonds, and tax-exempt versus taxable bonds, because investor preferences are shaped and molded by new tax policies.
Securities Transaction Tax:
Separate from taxation of interest, dividends and capital gains are questions about possible securities transfer taxes which we will discuss another time.
In addition to a possible replay of old tax policies, there are new tax approaches arising and possible.
For example, the Build America Bonds, which pay states to issue fully taxable muni bonds may be a wolf in sheep’s clothing. Although it helps states raise money, it may also be on the way to extinguishing the supply of federally tax-exempt bonds (something the feds have long wanted to kill to keep the money flowing to Washington).
It is also conceivable that tax-exemption could be phased out for the “rich” as they are defined by Congress.
In any event, you may find it useful to review the history of dividend and capital gains tax treatment since income taxes were instituted in the US in 1913. The tables that follow summarize the top marginal rates for corporations, individual ordinary income, dividends and capital gains since that fateful year — 1913.
There were various taxes prior to 1913, but in that year the 16th Amendment to the Constitution made the income tax permanent. The amendment gave Congress legal authority to tax income of both individuals and corporations.
16th Amendment text:
Article XVI: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
Muni Bonds in the Cross-Hairs?
The phrase “from whatever source derived” allows as much creativity on the part of Congress as they can conjure up. If they can muster the political wedge (such as bailing out California) they may be able to tax all muni bonds too. We already know from the way the auto company bankruptcies were handled that prior rights of bond holders will not necessarily be honored and upheld. We hold it to be quite conceivable that muni bonds, including previously issued bonds, could become fully taxable at the federal level. The easiest way to do that, and the easiest way to sell that to the public, would be to maintain tax exemption for the “middle class” but to eliminate the exemption for the insurance companies that own them and to phase out the benefit for the “rich” (as they define it) through the AMT.
Equity-Income Could Be In Trouble:
If equity income investors get a larger share of total return from dividends than other equity investors, and if dividend taxes go from 15% tax to 39.6% tax (a 1.6 times increase), while capital gains go from 15% to 20%, we see the equity-income style suffering a big hit. Let’s hope, Congress keeps a more level playing field between capital gains and dividends.
We are not accountants or tax advisors, but we are trying to become junior tax historians. The following historical tax tables are cobbled together from various sources. They probably contain errors, but they are probably good enough to fairly present the approximate lay of the land as it evolved over time. If you find errors, let us know and we will amend the tables.
Representative Securities That Could Be in Policymaker Sites:
These securities represent categories that may exhibit differential performance response to the new tax regime we face in less than 1 year:
- SPY (large stocks in general)
- SDY (equity-income stocks)
- BND (bonds in general)
- MUB (municipal bonds)
- VNQ (real estate investment trusts)
- BPL (pipeline limited partnerships)
- TIP (inflation protected Treasuries)
- GLD (currency alternative)
Corporate Tax Rate History:
The top corporate income tax rate in 1913 was 1%. The highest top rate since 1913 was 52% in 1952-1963. The current top rate is 35%.
Top Individual Ordinary Income Tax Rate History:
Top marginal tax rates (not average rates or rates after exemptions and deductions) in the US from 1913 (source: Truth In Politics) are in this table. The top rate was effectively 90% in 1944. The lowest rate was 7% in 1913. The current top rate is 35%, and expected to go to 39.6% (or higher in 2011).
Here is a table of the top marginal rates:
Individual Top Dividend Tax Rates History:
The top rate was “fully taxable” as ordinary income in 1936-1939 (79%), and 1985-2002 (28% to 50%). The lowest rate was “exempt” (0%) in 1913-1935, and in 1940-1953.
Individual Top Capital Gains Tax Rates History:
The top rate was 49.88% in 1977. The lowest rate was 7% in 1913-1921. The current rate is 15%, expected to go to 39.6% or more in 2011. By capital gains, we refer to long-term gains, however they were defined in each tax year.
History of capital gains taxation in the United States (October 1999, from Urban Institute):
From 1913 to 1921, capital gains were taxed at ordinary rates, initially up to a top rate of 7 percent. Because of concern that the higher income tax rates introduced during World War I reduced capital gains tax revenues, from 1922 to 1934 taxpayers were allowed an alternative tax rate of 12.5 percent on capital gains on assets held at least two years. From 1934 to 1941, taxpayers could exclude percentages of gains that varied with the holding period. For example, in 1934 and 1935, 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively. Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent. Capital gains tax rates were increased significantly in the 1969 and 1976 Tax Reform Acts. The 1969 act imposed a 10 percent minimum tax, excluded gains, and limited the alternative tax to $50,000 of gains. The 1976 act further increased capital gains tax rates by increasing the minimum tax rate to 15 percent. In 1977 and 1978, the maximum tax rate on capital gains reached 39.875 percent with the minimum tax and 49.875 percent including an interaction with the maximum tax. In 1978, Congress reduced capital gains tax rates by eliminating the minimum tax on excluded gains and increasing the exclusion to 60 percent, thereby reducing the maximum rate to 28 percent. The 1981 tax rate reductions further reduced capital gains rates to a maximum of 20 percent.
The Tax Reform Act of 1986 repealed the exclusion of long-term gains, raising the maximum rate to 28 percent (33 percent for taxpayers subject to certain phaseouts). When the top ordinary tax rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was provided. Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of interactions with other tax provisions. The new lower rates for 18-month and five-year assets were adopted in 1997.
[QVM Note: Capital gains were taxed at 20% from 2000-2002. They were/are taxed at 15% through 2010. They are expected to be taxed at (or higher) than 2002 rate of 20% in 2011.]
Detail of 2010 and 2011 (expected) Capital Gains Tax:
This table is from the Tax Foundation.
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Holdings Disclosure: As of February 17, 2010, we own SDY, MUB, TIP and GLD in some, but not all managed accounts. We do not have current positions in any other securities discussed in this document in any managed account.
Disclaimer: Opinions expressed in this material and our disclosed positions are as of February 17, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.